Bonus culture

Diane Coyle has an excellent article in the FT about an apparent puzzle. Why do executives get incentive bonuses (extra pay on meeting some target), but most workers do not? Her article is based around a classic paper by Bengt Holmstrom and Paul Milgrom. Their basic argument is that incentive pay linked to specific targets works (it increases effort) when tasks are simple and effort can be easily measured. However if tasks are complex, and only some aspects of performance can be accurately measured, incentive pay can distort the allocation of effort between those tasks, leading to undesirable outcomes. As Diane says “pay structures not only incentivise effort and direct risk-taking, they also determine the worker’s allocation of effort between different tasks.”

So target related bonuses make sense for workers conducting simple tasks where effort can be easily measured, but are a bad idea for workers undertaking complex tasks where only some aspects of performance can be measured. To quote Diane:

“Indeed, the best arrangement would seem to be the opposite of the pattern we observe now. Corporate executives and senior bankers doing complex jobs involving many impossible-to-monitor activities are the last people who ought to be paid via an incentive scheme; while bonuses for fast-food workers or shop-floor employees make more sense.”

The implication she draws is straightforward: the bonus culture for corporate executives and senior bankers should end. But this leaves us with a puzzle: why did this bonus culture arise in the first place? Perhaps bonuses created something beneficial that we are missing.

Here is a simple conjecture, based on another paper by Piketty, Saez and Stantcheva which I discussed here. They note that increases in executive pay are strongly correlated with reductions in the top rate of income tax. Their explanation notes that executive pay is the result of bargaining between the executive and the firm. The executive has a lot of bargaining power (what successful firm wants their CEO to quit), but whether they choose to use it depends on the reward from doing so. If top tax rates are low, the rewards are high.

The executive still has to convince their firm to pay them more. What better way to do this than to suggest they get paid a lot more only if the company is successful. In the climate of the 1980s and 1990s in the UK and US (when the income share of the 1% took off) that argument would have seemed pretty convincing. My conjecture therefore is that bonus pay became endemic among executives and senior bankers not because it was more efficient for the firm, but because it was a useful tool in a bargaining game. [1]

This argument completely reinforces Diane’s conclusion. Executive bonuses are a way for senior management to extract rent from their firms, which is a quick way of saying that these high salaries redistribute money from everyone else to themselves. A consequence was that they reduced efficiency by diverting the executive’s attention to just hitting specific targets. One final thought, as we in the UK are obsessed with Brexit right now. It was the EU that passed laws limiting bonuses in the financial sector, and it was George Osborne that spent the UK public’s money trying to stop that law coming into effect.

[1] Bonuses can play a useful role in small firms where revenues are volatile, as Chris Dillow notes. That argument hardly applies to the CEO of a large multinational.